Shining More Light on Dark Pools

Recent developments that call into question dark pool trading activities may not deter institutional investors from seeking out alternative trading venues and taking full advantage of their benefits. The most recent development saw the Securities and Exchange Commission fine dark pool operator eBX ­ which runs Level ATS  $800,000 in October for allegedly failing to protect customers confidential trading information. But if more such cases arise, investors will likely start looking more closely at whether the venues deliver what they promise.

Thats the finding of Woodbine Associates, a capital market research and consulting firm based in Stamford, Connecticut. It advises clients on dark pool selection and released a report in September on current dark pool trading activity.

Despite SEC charges brought against eBX, institutional investors need dark pools more than ever today, says Matthew Samelson, principal at Woodbine Associates. Samelson points out that because todays traditional display markets such as the New York Stock Exchange or Nasdaq trade at lightning-fast speeds, the buy-side institution that is not a low latency or high frequency trader is at a distinct disadvantage.

It behooves these institutional traders to trade in dark pools where they have some control over who they interact with, can have anonymity and more protection against leakage than one gets in the display markets and thus, can achieve some kind of trading price improvement, he said. Currently, there are more than 40 dark pool trading venues operating in the United States.

As an example of dark pool benefits, Samelson said that a firm that wishes not to interact with high frequency trading flow or with another type of counterparty can  depending on the dark pool they use ­ utilize controls to achieve that goal.

According to Dark Pools: Characteristics, Operations & Liquidity, an analysis of 25 different dark pool trading venues issued by Woodbine Associates in September, off-exchange transactions account for 27 percent to 34 percent of all U.S. equity securities volume, with dark pools representing a smaller but persistent proportion of that volume, growing from 8 percent of the consolidated tape share volume in 2008 to approximately 13 percent today.

But if institutional investors continue to trade in these opaque trading venues, is there a way for them to avoid questionable practices?

Samelson says that for now, their options are limited. If someone misrepresents something to you, either by omission or intentionally, there is no way you can find out whats really going on, short of doing your own internal audit of the situation, he said.

However, he acknowledges that recent events may make some people ­ both institutional and Main Street investors  quite nervous about market operations.

The eBX episode is one of several that have raised questions of late concerning dark pool operations. The firm was sanctioned by the SEC and paid a penalty but did not admit or deny wrongdoing. Earlier in June alternative trading network Liquidnet Holdings said that the SEC was investigating how it manages information about the firms using its platform. And the previous October, Pipeline Trading Systems paid a $1 million penalty to the SEC to settle charges that the broker failed to disclose to customers that a majority of orders were not processed as advertised, that is, matched against other Pipeline customer orders. Instead, a majority of orders were filled by a wholly owned trading affiliate of the firm. As with Liquidnet, Pipeline did not admit or deny the charges. As a result of such developments, Samelson says Woodbine sees a business opportunity and is looking into the possibility of conducting trading audits and validating the operations of dark pool venues for the benefit of institutional clients.

A validation would involve numerous audit-type features to basically ensure that what a dark pool specifies is the case  in terms of their operations and practices [are], in fact, as they say, he says.

The validation service would be provided to and paid for by dark pool operators who hope to attract and retain their institutional trading customers. It could involve a comprehensive review of business processes or alternatively, a more selective review and audit of the code underlying their matching engine to validate that the way management or a sales team says an offering works is truly the way it operates. The scope of such work is likely to be dependent upon what the dark pool thinks is necessary, Samelson said.

He adds that Woodbine is in talks with certain dark pools to validate their operations.

Industry observers say such a service would be a first. Currently, industry surveys such as the TABB Groups Liquidity Matrix and the monthly Let There Be Light activity reports, issued by institutional broker-dealer Rosenblatt Securities, report on dark pool trading volumes and pricing activity. But there do not appear to be any other organizations that offer something akin to an audit or validation of dark pool operations. The TABB Group, for example, reports that to their knowledge, no such service exists.

You would think that the regulators would be doing that (providing audits of dark pool activity) already, says Joe Saluzzi, co-founder at Themis Trading, an independent, institutional agency broker based in Chatham, New Jersey, and a frequent critic of the trend toward what he calls an uneven playing field in markets. He adds that while he would welcome the existence of such a service, if a pool did not want to be validated, you would certainly have to ask why.

Others questioned whether dark pools would be willing to disclose much about their operations.

David Mechner, CEO at Pragma Trading, a New Yorkbased provider of advanced trading tools, observed that before anyone even attempts to audit a dark pool, one would have to get dark pool operators  in particular, broker-sponsored dark pools  to articulate more clearly what their rules of operations are, something that would be very difficult to do. For all the noise about exchange order types, 30-plus percent of volume is done off exchange, much of it in broker-sponsored dark pools with very little disclosure about the rules for how those orders are handled.

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